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Investing in Commodities

Given the record values commodities hit in 2010 and the fact that they’ve suffered a slump so far in this still-new year, should anyone be thinking about adding commodities to their portfolio now? Some experts say yes.

In recent years there’s been increasing evidence that commodities can be both a hedge against inflation and provide balance in a portfolio, often moving up when other assets move down.

Now John L. (Launny) Steffens adds another argument for commodities in 2011: they may provide the safest way to benefit from growth in emerging markets.

Commodities and Emerging Markets

Steffens is founder of Spring Mountain Capital, a New York-based alternative investment firm that managed more than $1.5 billion in wealthy individuals’ investments, most of that by investing it in hedge funds and private equity partnerships. Before starting the firm in 2001, he worked for 38 years at Merrill Lynch, running some of their largest business lines.

Steffens is recommending investors buy into commodities in 2011 as a way to get in on continued growth in emerging markets, with a limit on the downside risk. Commodities, Steffens argues, give you exposure to emerging markets growth (since those market’s demand drives rising need for oil, commercial metals, beans, and other commodities) but if those fast-growing regions should for some reason hit a bump, commodities could still be a winner as a hedge against the inflation that might come with such a slow down.

The material related commodities sector had a terrific run in 2010, because the sector was so depressed in 2009 and rallied off those bottoms. . . . Still companies in that sector are likely to have quite good earnings going into 2011. In terms of emerging markets, if the sector continues to do well from a GDP (Gross Domestic Product) growth standpoint, the traditional commodities sectors, such as metals, oil, should continue to perform. The softer agricultural commodities will continue to do well also. . . .

If those markets don’t do well, my sense is that commodities will do better than the general emerging markets companies because you don’t necessarily have to deal with things like corporate governance and (different) legal systems. The companies we’re talking about are largely US or outside the emerging markets. . . . We feel, probably starting late in 2011 that we’re going to begin to see some increasing inflation numbers. Even if there’s a pullback in the emerging markets we think commodities should benefit from the people looking at the inflation numbers, [these commodities companies] will have the raw materials in the ground and have the ability to capitalize on the assets they have there.

Over the longer term, five years plus, Steffens sees no reason why emerging markets won’t continue to drive demand for commodities, for all the regular reasons.

If you think about the 6 billion people in the world, probably 60% of those or more live in emerging market countries. As they continue to improve in terms of their standard of living there will be more pressure on agricultural products. Countries will continue to move from carbohydrate consumption to protein consumption, and that has a big impact on the total agricultural sector. Agriculture has a big benefit in terms of those trends being very long term and quite positive for the next several years. . . .

That doesn’t mean emerging markets will be “bump free” Steffens says. At the moment he doesn’t see anything foreboding on the horizon in 2011, “but could it happen? Our answer is yes.”

Portfolio Investing and Commodities

Moneywatch columnist and author Larry Swedroe, has written often about investing in commodities, most extensively in his book The Only Guide To Alternative Investments, but also in his latest book The Only Guide You’ll Ever Need for the Right Financial Plan.

To Swedroe the best argument for commodities isn’t their potential for high returns, but rather all the good things they do for a portfolio, like provide insurance against some risks and a hedge against unexpected inflation. He doesn’t worry much about the fact that commodities have traditionally been quite volatile. It’s how they act in combination with other investments that interests him.

Commodities act as an insurance policies hedging some but not all risks. The types they hedge are some event risks that disrupt supplies (wars for example) and also unexpected inflation. Commodities have had negative correlation to bonds and basically have been uncorrelated with stocks. So [investors] that own longer bonds that are nominal, they too should consider owning commodities to hedge that risk of unexpected inflation… A big mistake investors make when thinking about assets is that they think about them in isolation when the ONLY right way is to think of them in terms of how their addition impacts the risk and return of the PORTFOLIO. And when you have negative correlations with other portfolio assets high volatility is actually a GOOD, not a bad thing. So the volatility of commodities should not bother you. In fact, it is the high volatility that allows for a small allocation to have a meaningful impact.

This year, or any year, what matters when an investor is thinking about making that allocation to commodities, Swedroe says, is the answer to this question: “Do you need commodities to help cut the tail risks in your portfolio?” “If the answer is yes,” says Swedroe, ” I would consider buying. If not, then no need to.”

I would think about it this way: Does the addition of the asset reduce the risk of fat tails? This is especially important for those in the withdrawal phase. Commodities have gone up in all but three of the negative years for stocks since 1970 and in ALL the years of negative bond returns. That cuts tail risks.

The Best Way to Invest in Commodities

Steffens says he thinks ETFs are a good investing vehicle for commodities for most investors. Rather than ETFs that hold the commodity itself, like GLD, or companies that are end users of a commodity, he prefers funds that hold the producers of the raw material, those with hard assets in the ground. That connects back to the firm’s expectation that inflation could rise later this year, and that will squeeze any companies that can’t easily hike prices.

If wheat and grain prices increase because of demand or weather related issues, cereal makers will have some difficulty passing on those increased prices. On the other hand, the copper or gold [miners] will have less of a hard time doing that because they own the raw material. They will be the primary beneficiary.

Questions About Commodities and Diversification

One of the arguments against the idea that commodities — or almost any sector really — is a reliable balance to stocks the fact that almost all sectors have been moving in tandem in the last two years. Both up and down. Steffens acknowledges that in recent years different sectors — like commodities and stocks — have not provided the varied performance that they traditionally have to balance portfolios. But he expects that to change. “Sector selection is critical in terms of investing,” Steffens says. “2010 was an interesting year, the difference between the best sector and worst was amongst the lowest in the last 20 years and probably the lowest in the last 50 years. . . Because the recovery from 2009 and 2010 was fairly consistent across groups and many sectors were depressed, they all went down equally and came back equally. Our view is 2011 is a period when we’ll begin to see more difference again.”

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